10 Answers

When central banks decreased interest rates and embarked on QE, there were widespread worries that it would lead to excessive risk taking. Investors would want to maintain the same rates of return by taking more risk. Borrowers would be attracted by low rates and accumulate excessive levels of debt.

Looking at the evidence today, it looks like risk taking has been actually quite limited. Stock prices are high, and so are P/E ratios, but these reflect low safe rates, and the equity premium does not seem abnormally low. Banks have shed many risky assets. Securitized lending has expanded, but securitization is not by itself a bad thing---even if the previous incarnation turned out to be catastrophic. Institutions such as insurance companies or defined benefit pension plans have increased the proportion of alternative, higher yielding, assets but it is not seen as representing excessive risk. Households and firms have develeraged. Public debt, in ratio to GDP, after the increase due to the recession, has stabilized in most countries. Some emerging market countries may have borrowed too much, but this is about it.

Am I much too optimistic? I welcome contradictions, and references to empirical work and evidence.

I'm not sure about "excessive", but it seems pretty clear that the low interest rates (plus QE) of the last several years have led to significant downward pressure on a variety of risk premiums. Credit spreads are somewhere between the 10th and 20th percentiles of their historical range. Term premiums on Treasury securities are, according to most models, negative. And stock prices do seem quite high relative to fundamentals. Moreover, a superficial glance at the evidence suggests that elevated stock prices are in part due to a wave of corporate stock repurchases. And we know that repurchases tend to be higher when credit spreads are low, as firms find it attractive to borrow to buy back stock. Thus it is likely that at least part of the stock-price impetus can be traced to the same low-rate forces that have compressed credit spreads.

Of course, all of this is to be expected, and was explicitly intended to be part of the transmission mechanism for low rates--the so-called "portfolio balance" channel, which is a nicer and more politically correct euphemism than the "risk-taking" or "reaching for yield" channel. But they are all the same thing, and indeed, we have been fortunate that monetary policy has these risk-taking effects, because this gives it more potency per unit of funds-rate-cut, which is a crucial benefit near the zero lower bound.

As for "excessive", the above suggests that the flip side of any aggressive monetary stimulus, especially near the ZLB, is some elevated risk of a financial reversal further down the road. Again, this is not in itself a bad thing--it is just how monetary policy works. If one does not take some such risk when the unemployment rate is at, say, 8%, then one is probably not trying hard enough. So "excessive" completely depends on the context, and the relevant tradeoffs. By contrast, if we were at full employment and (counter-factually) inflation was stubbornly stuck at 1.5%, a hyper-aggressive monetary policy that disregarded financial risks, in a single-minded effort to return inflation to 2.0%, might well be said to be creating excessive financial risk.

In a complex financialized global economy - it is very difficult to answer at what point risk taking becomes excessive. Maybe the right way to think is the incentive structure that QE/low interest rates have created. For example:
1. If a central bank conducts monetary policy by buying credit risk what incentive does private sector have to carefully evaluate credit risk
2. If hurdle rate for investments is made zero, why should speculative capex not explode? I.e maybe invest some part of money in 10x/20x. Case in point being explosion on venture capital funds.

There are a few other examples we can give but I think it is very difficult to define excessive risk taking. We would not know the vulnerabilities till they are exposed. However maybe there is an argument that QE has affected incentive structure for capital allocation.

Jeremy, in your time as a Fed Governor, you argued that, at least in theory, "a more accommodative [monetary] policy might entail a heightened risk of some sort of adverse financial market outcome" (in your 2014 speech: https://www.federalreserve.gov/newsevents/speech/stein20140321a.htm). You were careful to say then that empirical magnitudes of financial stability risks were less clear. Olivier's question sounds like a look back on the actual experience of recent years. Do you think empirically the financial stability risks of low rates ended up being less than you expected in 2014? Neil Irwin's article from this weekend https://www.nytimes.com/2018/09/29/upshot/mini-recession-2016-little-known-big-impact.html discusses other imbalances, like differences in rates across economies, dollar appreciation/emerging markets, and oil price declines that seemed to negatively affect the U.S. economy after the Fed raised rates at the end of 2015. With (some) benefit of hindsight, did this episode change your views any about the relative risks of low rates?

Re: "Of course, all of this is to be expected, and was explicitly intended to be part of the transmission mechanism for low rates--the so-called 'portfolio balance' channel, which is a nicer and more politically correct euphemism than the 'risk-taking' or 'reaching for yield' channel. But they are all the same thing, and indeed, we have been fortunate that monetary policy has these risk-taking effects, because this gives it more potency per unit of funds-rate-cut, which is a crucial benefit near the zero lower bound..."

"Portfolio balance" connotes organizations that understand the risks responding to changing spreads by... rebalancing their portfolios... in a sensible way...

"Reaching for yield" connotes organizations that find their old business models unsustainable taking on risks they do not really understand and cannot evaluate well...

I like to look at the bigger picture... for society. Inequality is continuing to grow in the US. There is a debate if low interest rates have caused inequality to grow. But one thing is certain, if you have money, it is easier to borrow money. So liquidity has increased in the upper incomes.
So do we see risk taking in the lower incomes? There is increased drug use. Even the issue of exploding student loans reflects increased risk taking.

Claudio, thanks for the ref. I read the introductory remarks, and it looks as if we are looking at the same glass: Things roughly ok, with some worries about EMs. You see (more than) half empty, I see as (more than half) full. Evidence on low rates leading to higher risks (as opposed to the existence of risks for other reasons, from Trump to oil prices) seems missing.

Olivier, sorry for getting back to you so late. Just a couple of points.

You are right that what I sent you does not document specifically the link between low rates and risk-taking: this is just an overview of recent developments in financial markets and that was never the intention. That said, there is by now a large empirical literature that does document the link (and Luc refers to some of it). In fact, market participants might well be puzzled about us even raising the question.

Establishing what is “excessive” is hard without a clear benchmark. In the paper with Haibin Zhu in which we coined the term “risk-taking channel” of monetary policy and outlined possible mechanisms, we were careful to state that this mechanism is always at work: the induced risk-taking need not be “excessive”; seeOlivier, sorry for getting back to you so late. Just a couple of points.

You are right that what I sent you does not document specifically the link between low rates and risk-taking: this is just an overview of recent developments in financial markets and that was never the intention. That said, there is by now a large empirical literature that does document the link (and Luc refers to some of it). In fact, market participants might well be puzzled about us even raising the question.

Establishing what is “excessive” is hard without a clear benchmark. In the paper with Haibin Zhu in which we coined the term “risk-taking channel” of monetary policy and outlined possible mechanisms, we were careful to state that this mechanism is always at work: the induced risk-taking need not be “excessive”; see https://www.bis.org/publ/work268.htm . As Jeremy points out, context matters.

But, more generally, this does not strike me as the most fruitful way of asking the question. A more fruitful one is to ask whether we see signs of high risk-taking and of the build-up of vulnerabilities in markets and the financial system – vulnerabilities that can threaten the economy at large. The BIS Quarterly Review points to a number of them, in both advanced and emerging market economies. Hence the reasons for concern.

But, more generally, this does not strike me as the most fruitful way of asking the question. A more fruitful one is to ask whether we see signs of high risk-taking and of the build-up of vulnerabilities in markets and the financial system – vulnerabilities that can threaten the economy at large. The BIS Quarterly Review points to a number of them, in both advanced and emerging market economies. Hence the reasons for concern.

Especially at a moment like present I think Olivier is wrong to blame low rate primarily on QE. Term structure is pretty flat. Stock of long term debt markets have to absorb is high by historical standards. Very long run forward real rates are low. I think low rates have to do much more w fundamentals that have reduced r star than w qe.

I’m less confident than Olivier that risk premiums are low. For equities his judgement relies on assumption that super high earnings will be highly persistent. Commercial real estate,covenant lite lending, and credit spreads are along w emerging markets more alarming.

Even if Olivier is right that high asset prices are justified by low Long rates that does not mean they are not a source of risk. Longer duration assets are more risky. When assets are more valuable relative to income spending is more sensitive to a given fluctuation in their value. Also there are surely some funds who are increasing their risk taking.

It will always be true that asset prices can be justified w some kind of fundamental story. See Jeff Sachs on Japanese land in 1989 or stories about equity cross holding or Fama during the nasdaq bubble. If no story a bubble would collapse so I’d be wary today.

The right understanding of secular stagnation is not that economy will always be stagnant but that in order to achieve full employment and sustained growth u need some combination of risky financial conditions and fiscal deficits at levels traditionally regarded as dangerous. I think the secular stagnation idea is being confirmed around the industrial world.

Larry: My point was not about the absence of risks. There are always plenty of risks, from sharp dollar movements or unexpected tightening by the Fed. It was about whether low rates per se had led to more risks. I do not see anything in your comment which points to that (unless you count the mechanical effect of lower rates on effective duration).

Investors wanting high rates of return and taking on crazy risky ideas? Are not many of the silicon firms which have high valuations even while never earning a profit an example of this?

Take UBER, or LYFT, companies which subsidize each ride by about 1/3. Their only hope for profitability is removing human drivers which is probably decades away even though they have only 3 years of runway given current capital. Or Snapchat, which has billions of dollars in its valuation, but continual losses and a limited revenue stream. Are users and data worth that much even the company has no revenue to speak of itself? There's also juicero, or theranos. How can to good to be true companies get millions of capital with no product (or crazy products, like wifi enabled bag squeezers).

I think there would have been more risk taking if capital had not received so much support financially. Even now with taxes dropping fast, there is less desire to take risk. I am saying that government actions probably neutralized the risk, which is not really a good thing. Risk allows companies to invest in more productive operations. And as we see, productivity did not increase much possibly showing that more risk should have been encouraged in the economy.

I suspect that the right way to make the accurate point that this line of discussion is hunting for is to focus not on the amount of risk but on, rather, who is bearing the risk...

Think of it this way:

Let me first outline what is the wrong focus—on the quantity of risk being carried: In the financial market there is a demand for risk-bearing capacity by firms and others who want to borrow but who cannot guarantee that they will be able to repay. The higher is the price of risk—the greater the risk premium interest rate spread over short-term Treasuries they must pay--the less they will borrow. There is also a supply of risk-bearing capacity by savers and financial intermediaries who want to lend, and are willing to accept and bear some risk in return from getting more than the short-term Treasury rate. The higher is the price of risk—the greater the risk premium interest rate spread over short-term Treasuries they must pay--the more they will be willing to lend.

When the Federal Reserve undertakes quantitative easing, it enters the market and takes some risk off the table, buying up some of the risky assets issued by the U.S. government and its tame mortgage GSEs and selling safe assets in exchange. The demand curve for risk-bearing capacity seen by the private market thus shifts inward, to the left: a bunch of risky Treasuries and GSEs are no longer out there, as the government is no longer in the business of soaking-up as much of the private-sector's risk-bearing capacity. And this leftward shift in the net demand to the rest of the market for risk-bearing capacity causes the price of risk to fall, and the quantity of risk-bearing capacity supplied to fall as well. Yes, financial intermediaries that had held Treasuries and thus carried duration risk take some of the cash they received by selling their risky long-term Treasuries to the Fed and go out and buy other risky stuff. But the net effect of quantitative easing is to leave investors and financial intermediaries holding less risky portfolios because they are supplying less risk-bearing capacity.

How do we know that they are holding not more but less risky portfolios? We know because we know that supply curves slope up, and if they were holding more risky portfolios in total—supplying more risk-bearing capacity to the market—the price of risk would have not fallen but risen, and interest rate risk spreads would be not lower but higher, wouldn't they? At least, that is the case as long as the supply curve for risk-bearing capacity slopes up, like a good supply curve should.

Perhaps those who claim that there are big risks to quantitative easing regroup. Perhaps they claim that financial intermediaries are perverted, and that the lower is the price of risk the greater is the amount of risk-bearing capacity they supply to the market because they lose their jobs if they don't make at least three cents on every dollar of assets in a normal year in which risk chickens come home to roost. But in that counterfactual world, the Federal Reserve's adoption of quantitative easing policies triggered an enormous expansion of the quantity of risk-bearing capacity demanded by firms and households and a huge private-sector lending boom as firms issued enormous tranches of risky bonds and as firms and households took out risky loans. In that counterfactual world, employment in bond underwriting tripled as 85billionamonthinQEwasmore−than−offsetbyanextra
120 billion a month in private-sector bond issues. In that counterfactual world, we saw a rapid recovery of housing construction and a thorough equipment investment boom as far across the U.S. as they eye could see.

That didn't happen. So what are the risks of QE, really?

Let me now analyze what is the right focus::

* Commercial banks traditionally accept deposits, put the deposits in long-term Treasuries or similar low-risk high duration assets, rely on the law of large numbers and on deposit insurance to allow them to always hold their long-term Treasuries or other low-risk high duration to maturity, and so have a profitable business model as long as they focus on what their core competence is: running a commercial banking business with branches, ATMs, and a well-collateralized loan portfolio.

* When commercial banks cannot do this profitably, they need to find higher return assets to invest in. The problem is that they have no expertise in judging those higher return assets—hence they are highly likely to get adversely selected as they try to find them.

* The result is that they are likely to lose money. And then somebody will have to eat the losses.

To the extent that organizations whose business models become unprofitable as a result of low rates and QE and so take on risks **excessive for them because they have no expertise in judging such risks** do so by investing government-insured deposits, this is not a source of systemic risk to the economy: it is only a source of financial risk to the Treasury.

To the extent that organizations whose business models become unprofitable as a result of low rates and QE and so take on risks **excessive for them because they have no expertise in judging such risks** do so by investing non-insured deposits, this could be a source of systemic risk to the economy depending on where the funds are coming from, and how highly leveraged the organizations that these funds are being drawn from are.

At least that is what I think a coherent and possibly accurate worry might be...

An easily accessible measure of risk appetite is the excess bond premium introduced by Gilchrist and Zakrajšek (2012). It is currently low, indicating a high risk appetite. The high yield spreads available on FRED are similar (e.g., series BAMLH0A3HYC). These series do not appear to be strongly correlated with interest rates, though, so they do not imply that interest rates are the cause or that the risk appetite is "excessive".

1) With plenty of caveats on measurement issues, the evidence suggests that the equity risk premium began to rise in the early 2000s, spiked during the crisis, and have now "converged" to levels that are higher than historical averages. If this is the new -normal, it may well be the case that interest rates will remain low for a long time. But this is an equilibrium, not evidence that there is no speculation. In fact, this high ERP is taking place in an environment with very low realized volatility. If volatility were to rise to more normal levels, equity values may drop sharply to be consistent with the new-normal for ERP.

2) The impact of QE on ERP is very indirect. Much more direct is its impact on credit spreads in DM and EM. These do look stretched to me.

3) Having said (1) and (2), I think extended QE was necessary to boost AD in an environment with fiscal and income distribution drags.

4) But we have yet to see whether this new environment in which a large share of AD is being supported by high valuations rather than more stable sources will bring about higher macroeconomic volatility in the near future

I find myself thinking that Shiller's CAPE estimate of valuations with respect to fundamentals has a lookback earnings window that extends back to 2008Q3, and so implicitly assumes that the economy undergoes one Great Recession a decade. A less rigid lookback window for calculating permanent earnings would be more optimistic about earnings fundamentals, and would show less elevated risky asset valuations.

As I see it, risky asset valuation ratios look fairly normal. It is, of course, as you know at least as well as any of us, safe asset valuations that are stratospherically high. And that, of course, as you know at least as well as any of us, goes with an equity return premium that is higher than historical averages. And, of course, as Philippe Weil taught us more than three decades ago (or ought to have taught us: I still find this a strangely underappreciated point), the big puzzle is a low risk-free rate puzzle rather than a high required equity returns puzzle...

Would you mind elaborating a bit more on your comment about safe assets valuations?

The language used in the original question and much of the thread refers to excessive risk and the risk-taking channel, but I found the emphasis of Caballero & Krishnamurthy (2009) on demand for riskless assets leading into the crisis more illuminating. I think Bernanke et al’s (2014 ) IFDP does a good job of documenting these patterns, particularly foreign demand for MBS. Do you think any safe-but-slightly-risky asset classes might be at risk for causing spillovers like those seen with demand for MBS? Or any possible issues if global interests rates rise and this demand for US safe assets subsides?

When lowering the interest rate, the central bank reduces the rewards for saving in safe assets. In a sense, it tries to induce savers to shift their portfolio towards riskier asset classes. The question is whether this translates into more risky real investment or is simply used for speculative purposes (and stays in dangerous corners within the financial sector). The outcome depends to a large extent on the financial system (and its capitalization).

For the U.S., I believe it is worth watching what is happening in the shadow banking sector. If the build-up of risk is somewhere, it more likely to be there.

For Europe however, I feel the question goes the other way: have low-for-long rates caused a lack of risk-taking by European banks -- or rather, reduced their risk-bearing capacity? Low/negative rates have pressured banks' margins and overall profitability. To the extent that this has decreased their ability to take on (observable) risk amid rising regulatory pressure, the transmission channel might be less effective. The empirical literature is still divided on the "reversal" subject, given the important identification challenges. The question remains very open.

There is by now ample compelling evidence of the existence of a risk-taking channel of monetary policy, due to either risk shifting or search for yield (see, for instance, Dell’ Ariccia, Laeven, and Suarez 2016). However, whether such risk taking is excessive is a hard question because existing empirical evidence has nothing to say about the optimal level of risk taking. Still, based on the existing evidence I think one can reasonably conclude that at least for now risk taking has not been excessive. First, risk taking tends to fall during a recession so in the absence of accommodative policies there would if anything have been too little risk taking. Second, monetary policy affects risk taking through multiple channels that operate in opposite directions. While accommodative policy may boost the riskiness of bank activity through risk shifting or search for yield effects, it also boosts asset prices and economic activity through a traditional interest rate channel, speeding up loan recovery and strengthening bank balance sheets. Indeed, bank profitability has held up remarkably well despite concerns that low rates and flattened yield curves would render banks unprofitable. The traditional interest rate channel may well dominate the risk-taking channel of monetary policy during economic upswings. However the interest rate channel may at some point run out of steam as the economy reaches full capacity and loan recovery slows down. Moreover valuation gains from higher asset prices are one-off gains. At such point, the risk taking channel may start to dominate. I would therefore concur with concerns that if interest rates are held low for too long that risk taking may become excessive. This is particularly relevant in much of Europe where policy rates are not just low but negative.
A smaller point: The risk-taking channel is likely to be more pronounced when banks hold little capital/the financial system is distressed, as this reinforces risk shifting behavior by banks. Since the financial crisis, bank capital has been rebuild and the financial system is less leveraged. This development has if anything reduced the potency of the risk-taking channel.

Excellent discussion (and your paper on bank risk-taking is very nice!). One thing I think is worth adding: The interaction between bank risk-taking and the household balance-sheets channel may also matter. A greater risk appetite on the part of banks may be a greater problem when when MP makes household assets (like houses) expensive. Risk-loving banks plus risk-loving households sounds a lot like the potent brew that led to the financial crisis.

Low interest rates, when combined with preferential bank regulations, cause too much easy financing available for purchasing houses, which increases the price of houses, turning these from homes into risky investment assets, which sets us all up to a total disaster.

But it also pushes up the prices of financial assets to extremes, in the last decade, US stocks and bonds. Investors reaching for yield have entered asset classes, including stocks, junk bonds, and leveraged loans, that are unsuitable for them based on their risk profiles.

Valuation is a subjective thing, the price of an asset only reflects what the last buyer paid. We have no idea what kind of gap there can be between the current price and the next price because we do not know future events. I know equities, they can gap severely down on news that no one would have batted an eye about moments before.

Having been an institutional global equity investor during the wild Japanese equity market rise in the eighties, and having had a ringside seat to the debacle that followed, my belief is that low real rates create distortions that are very easy to rationalize away because to a certain extent prices are distorted by greed and hopes and dreams. Too much is made of market efficiency, too much is made of prices reflecting all known information, and too little is made of investors tendency of self deception and rationalizing past behavior.

In the last decade, too little attention has been paid to the huge amount of liquidity that was put into the system to prevent a collapse of the economy and the financial structure. But not everyone had access to very low or negative real rates. Very low rates distorted decisions made about investment - companies leveraging their balance sheet s to buy in shares rather than invest to improve their competitive position shows the emphasis on short term financial engineering over long term strategic positioning.

There is far too much debt worldwide that is not going to be paid back because much of it is not matched to assets that will create the cash flow needed to service it let alone repay it.

Low real rates got us out of one huge problem but has set us up for a perhaps bigger problem. Very clearly, individuals, corporations and governments are addicted to low rates and the withdrawal of liquidity is going to be painful for most.

I have no idea how to determine the "right" interest rate structure in a world where money flies around so fast, and where in the large economies of the U.S. and China the politics are driven by the need to keep unemployment low. (In fact the political stability of China hinges on whether the Communist Party can keep delivering a continuously higher standard of living).

Who knows what the right interest rate level is. What we are going to see is the interest rate that politics will allow. And we know politicians only focus on the next election. And that interest rate policy is over their heads.